GBP/USD gaining foothold & building support above 1.20 Inflation differential suggesting undervaluation below 1.25Implies GBP/USD fair value likely between 1.25 & 1.2850 But market bearish on outlook with key U.S. data looming

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The Pound to Dollar exchange rate entered the New Year with a solidifying foothold above 1.20 and inflation differentials suggesting that it is undervalued while below 1.25, although the risk is of important U.S. economic data leaning against any recovery by Sterling later in the week.

U.S. exchange rates were largely a directionless bag during the final week of the year and in price action that saw the Pound to Dollar benefit from a stubborn bid for Sterling down near 1.20 handle and at levels reflecting a hefty undervaluation of GBP/USD if inflation differentials are anything to go by.

Using the latest inflation and Bank Rate differentials to deflate from a January 2022 starting level around 1.3507 suggests GBP/USD is cheap while trading below 1.25 and that an appropriate trading range likely spans the gap between there and 1.2850 in rough and approximate terms.

However, the market remains bearish in its outlook for Sterling and the UK economy while there is a risk or chance that important pieces of pending U.S. economic data will provide the market with inspiration for fresh bids for Dollar exchange rates later in the week.

"A move through 103.50 in DXY [Dollar Index] might just be enough to drag GBP/USD off the lows and back through 1.2100, but I get the impression we'll end up below 1.2000 pretty quick in this pair," says Brad Bechtel, global head of FX at Jefferies.

Above: Pound to Dollar rate shown at daily intervals with Fibonacci retracements of late September recovery indicating possible areas of technical support for Sterling. Click image for closer inspection. If you are looking to protect or boost your international payment budget you could consider securing today's rate for use in the future, or set an order for your ideal rate when it is achieved, more information can be found here.

The Pound to Dollar rate fell by more than ten percent last year while gloomy expectations for the UK economy and a slower pace of interest rate rises from the Bank of England (BoE) relative to the Federal Reserve (Fed) were a key motivator of the still-bearish market.

"We look for GBPUSD to trade at 1.19 in 3M, followed by a rebound to 1.27 in 12M. 1.20 in cable is probably lower than its long-run equilibrium, and we look for a smaller net drag on the GBP from the BoP in 2023," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

"Moreover, the government's plans to rollback a portion of regulation affecting the financial sector could support net capital inflows. However, we also see a number of important risks which could slow the GBP's ascent in H1-23," Gallo writes in a recent year-ahead research briefing.

However, with the UK economic calendar offering little of note for Sterling during the opening week of the New Year, it's the action-packed U.S. calendar that is likely to pose risk or offer the opportunity for the Pound to Dollar rate in the days ahead.

"Tomorrow brings the minutes of the December 14 FOMC meeting, when the Fed lifted the end-2023 dot plot median to 5.1% (the high end of expectations) and Powell played down the significance of the softer October and November inflation reports," says Adam Cole, chief FX strategist at RBC Capital Markets.

While Wednesday's release of minutes from December's Fed policy meeting will be scrutinised closely by the market, the most important data point of the week is the release of December's non-farm payrolls report with its message about the strength of the U.S. labour market and outlook for pay growth.

"The first week of the new year US ISM, JOLTs, FOMC minutes (4 Jan), ADP (5 Jan) and NFP (6 Jan) are released - a key set of data that might lead to outsized moves at the start of the year. We expect that the message from the data to be the same," says Jordan Rochester, a strategist at Nomura.

"The US economy is slowing (lower ISM), job openings and job growth are slowing, with the Fed closer to the end of its rate-hiking cycle. For January as was the case in November and December, the key data release will be on 12 January, when December’s CPI figures are released," he writes in a recent research briefing.

Above: Pound to Dollar rate shown at weekly intervals with selected moving averages and Fibonacci retracements of 2021 downtrend indicating possible areas of technical resistance for Sterling. Click image for closer inspection. To optimise the timing of international payments you could consider setting a free FX rate alert here.